Index Mutual Funds: Investing Made Simple, Part 1

Index funds can make choosing investments easier. In addition, their low costs mean that they typically out-perform actively managed funds.

This post is adapted from a Plan Well, Retire Well blog post first written in 2013 for University of Illinois Extension. Used with permission

I would rather do lots of things than pick a mutual fund to invest in. Re-balancing my account isn’t high on my list of fun things to do, either. My guess is that most people don’t like these tasks any more than I do. So what happens? We procrastinate: these things are on my To-Do list, but I never seem to get around to them.

I have some good news for you. You may not have to do it all by yourself. Yes, you could hire an investment adviser and let them do decision-making, even manage the accounts for you, but that’s not what I’m talking about today. I’m talking about three tools that cost little or nothing and can make your life easier: index mutual funds, automatic re-balancing, and target date retirement funds.  

In today’s post, I’m going to talk about the one that you’re most likely to already know about: index mutual funds. What you may not have realized about index funds is how they can simplify your life.

Mutual Funds

Most of us know that we should diversify, or spread our investments across different companies and industries. If we invest in just one company or one industry, we are taking on much more risk: there’s a very slight chance that we could become millionaires! But there’s also a very real chance that we could lose some, or even all, of our investment if the company does badly or goes belly up. Diversifying by investing in a range of different companies and industries reduces both possibilities. Our investment results are more likely to be somewhere in between those extremes.

Investing in mutual funds rather than individual stocks is an easy way to achieve diversification. (Note: There are funds that intentionally focus on narrow sectors of the economy like energy, technology, or health care. If your goal is a well-diversified portfolio, you can ignore those.)

You may not be choosing individual stocks or bonds, but now you have to choose mutual funds! And there are LOTS and LOTS. Some invest in “equities” (stocks), others invest in bonds, and some are money market funds which would be considered a “cash”asset. And there are many funds that invest in more than one asset category. These may be called balanced or lifestyle funds. Target Date Retirement funds are a special type of fund that invests in more than one asset class. We’ll talk about those soon in another post.

Any given employer retirement plan will offer just a tiny, tiny fraction of those funds. But you still have to choose. How? Read the prospectus . . . Look at how long the fund manager has been there  . . .  Check how the fund performed in both good and bad markets  . . .  Figure out what its expenses are  . . . Are you tired yet?

Let’s look at how index funds can help us get past this roadblock.

Index Mutual Funds

While the fund manager(s) decide what to buy and sell in an actively managed mutual fund – index mutual funds are passive investments. They’re not trying to pick the investments that will do the best over the next week, month or year. Instead, their goal is to simply mirror the performance of an index that represents either an entire asset class (like the entire US stock market) or a portion of it (such as mid-cap US stocks).  You might recognize the names of some of these indexes, such as the Standard & Poor’s 500 (large-cap US stocks), the Wilshire 4500 (small- and mid-cap US stocks), MSCI EAFE (Europe, Asia and Far East stocks), or Barclay’s Capital Aggregate Bond Index (US bonds). The mutual fund will either own all the investments included in the index it tracks, or a mathematical representation expected to match its performance.

It’s may seem counterintuitive at first, but indexing beats most actively managed funds in most asset classes, most of the time. There’s tons of academic research on this, but  See Jeff Sommer’s article from Dec. 2022 in the New York Times tells the story nicely. This link will let you access the article for free until October 3, 2024 After that date, try this one.  

One of the reasons indexing beats active management is cost: index funds cost much less to operate, so the investor gets more of the returns generated by the investment. The expense ratio is a standardized way of calculating those operating costs – the percent of the amount invested in the fund that it costs to own the fund. Index mutual funds can have expense ratios less than one tenth of one percent (0.1%)> That’s $10 for every $10,000 you have invested. Actively managed funds, on the other hand, could have expense ratios of as much as one percent or even more (1.0%). That’s $100 for every $10,000 you have invested.

The other reason is consistency. An active fund manager might beat the index handily in one year, but trail it for the next 2 or 3. But the index fund is always, by definition, average.  

With an index fund, there’s no need to worry about how long the fund manager has been there, or how it did compared to other funds in up or down markets. All you really need to know is how you want to divide your money between different asset classes. Pick the index funds for those asset classes, and you’re done! A lot of new or small investors start with just a large US stock index fund or one that covers the entire US stock market.

Where to Invest in Mutual Funds

Your employer plan may offer index funds. For other accounts, you can access index funds by investing directly with the mutual fund company that offers them, or through a broker that gives you access to index funds from one or more mutual fund companies. In a brokerage account, check to see if there will be loads or commissions on purchases and sales.

Index funds are one of the tools that can make investing simpler and help end your procrastination. In future posts, I’ll introduce you to the other two: automatic re-balancing, and target date retirement funds.